Fiscal Competition，Soft Budget Constraints and Local Fiscal Sustainability

Abstract

Given the complex and severe external economic environment and the increasing downward pressure on the domestic economy, fiscal policy, as a structural policy, is expected to stabilize growth. However, affected by the implementation of tax and fee reduction policies, the cooling of land finance and the strict control of hidden debts, the pressure on local public finances has become increasingly prominent, and the space for proactive fiscal policies is limited. In order to make subsequent policies more steadily advancing in response to the downward pressure on the economy, on the one hand, we must ensure fiscal sustainability to provide guarantees for the stability and sustainability of economic operation; on the other hand, we must avoid preventing and controlling risks in a “one-size-fits-all” way to leave a cushion for expansionary policies. Therefore, under the current economic and fiscal situation, it is of great practical significance to scientifically understand local fiscal situation and examine the impact of key institutional factors on local fiscal sustainability based on the Chinese-style fiscal and political systems.Fiscal competition and soft budget constraints are the two core issues contained in the Chinese-style decentralization system, which have a profound impact on the fiscal behaviors of local governments. This paper integrates the two into a unified analytical framework, analyzes their impacts on local fiscal sustainability by distinguishing the modes of fiscal competition and the forms of soft budget constraints, and investigates the interaction effects between them. The results show that both tax competition and expenditure competition have a significant negative impact on fiscal sustainability. For different forms of soft budget constraints, the effect of transfer payments on local fiscal sustainability is uncertain, while land revenues and municipal investment bonds have a significant negative effect. Research on interaction effects shows that the interaction between transfer payments and fiscal competition is conducive to fiscal sustainability, but the interactions between land finance, municipal investment bonds and fiscal competition are not conducive to fiscal sustainability. Further research indicates that there is regional heterogeneity in the above effects.This paper proposes the following policy recommendations: Firstly, it is very necessary to establish a fiscal system that the revenue resources and expenditure responsibilities commensurate, reform the political promotion mechanism and establish a diversified performance evaluation system. Secondly, in the governance of excessive fiscal competition and soft budget constraints, the interaction between them should be considered. More specifically, central government may encourage standardized and orderly fiscal competition to reduce local government's reliance on off-budget revenue, and increase transfer payments to ease excessive fiscal competition. Thirdly, to ensure sufficient fiscal space and sustainable fiscal policies, differentiated designs should be made according to the economic development level and fiscal status of different regions, as well as the interactive mechanism between the modes of fiscal competition and the forms of soft budget constraints.